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Why Indexing Works
J. B. Heaton, N. G. Polson, J. H. Witte
Cornell University Library

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J. B. Heaton

∗

N. G. Polson

†

J. H. Witte

‡

arXiv:1510.03550v1 [q-fin.PM] 13 Oct 2015

October 2015

Abstract

**We develop a simple stock selection model to explain why active equity managers
**

tend to underperform a benchmark index. We motivate our model with the empirical

observation that the best performing stocks in a broad market index perform much better than the other stocks in the index. While randomly selecting a subset of securities

from the index increases the chance of outperforming the index, it also increases the

chance of underperforming the index, with the frequency of underperformance being

larger than the frequency of overperformance. The relative likelihood of underperformance by investors choosing active management likely is much more important than

the loss to those same investors of the higher fees for active management relative to

passive index investing. Thus, the stakes for finding the best active managers may be

larger than previously assumed.

Key words: Indexing, Passive Management, Active Management

∗

**Bartlit Beck Herman Palenchar & Scott LLP, jb3heaton@gmail.com
**

Booth School of Business, University of Chicago, ngp@chicagobooth.edu

‡

Mathematical Institute, University of Oxford, j.h.witte@gmail.com

†

1

Introduction

The tendency of active equity managers to underperform their benchmark index (e.g., Lakonishok, Shleifer, and Vishny (1992), Gruber (1996)) is something of a mystery. It is one thing

for active equity managers to fail to beat the benchmark index, since that may imply only a

lack of skill to do better than random selection. It is quite another to find that most active

equity managers fail to keep up with the benchmark index, since that implies that active

equity managers are doing something that systematically leads to underperformance.

We develop a simple stock selection model that builds on the underemphasized empirical

fact that the best performing stocks in a broad index perform much better than the other

stocks in the index, so that average index returns depend heavily on the relatively small set

of winners (e.g., J.P. Morgan (2014)). In our model, randomly selecting a small subset of

securities from the index maximizes the chance of outperforming the index - the allure of

active equity management - but it also maximizes the chance of underperforming the index,

with the chance of underperformance being larger than the chance of overperformance. To

illustrate the idea, consider an index of five securities, four of which (though it is unknown

which) will return 10% over the relevant period and one of which will return 50%. Suppose

that active managers choose portfolios of one or two securities and that they equally-weight

each investment. There are 15 possible one or two security “portfolios.” Of these 15, 10

will earn returns of 10%, because they will include only the 10% securities. Just 5 of the

15 portfolios will include the 50% winner, earning 30% if part of a two security portfolio

and 50% if it is the single security in a one security portfolio. The mean average return

for all possible actively-managed portfolios will be 18%, while the median actively-managed

portfolio will earn 10%. The equally-weighted index of all 5 securities will earn 18%. Thus,

in this example, the average active-management return will be the same as the index (see

Sharpe (1991)), but two-thirds of the actively-managed portfolios will underperform the

index because they will omit the 50% winner.

Our paper continues as follows. In Section 2, we develop our simple stock selection model.

In Section 3, we present simulation results. Section 4 concludes.

2

A Simple Model of Stock Selection from an Index

**We consider a benchmark index that contains N stocks S i , 1 ≤ i ≤ N . Let the dynamics of
**

stock S i over time t ∈ [0, T ] be given by a geometric Brownian motion

i

dSt+1

= µi dt + σ dWt ,

Sti

**where for simplicity we consider the volatility σ > 0 to be constant for all stocks. We assume
**

that stock drifts are distributed µi ∼ N (ˆ

µ, σ

ˆ 2 ), which generates a small number of extreme

1

**winners, a small number of extreme losers, and a large number of stocks with drifts centered
**

around µ

ˆ with standard deviation σ

ˆ > 0. While our model implies unpriced covariance

among securities and a lack of learning, much theory and evidence suggests that the learning

problem is too difficult over the lifetimes of most investors to pay much attention to that

modeling limitation (e.g., Merton (1980), Jobert, Platania, and Rogers (2006)). 1

For simplicity, we assume that individual stocks maintain their drift µi over the time

period t ∈ [0, T ]. We also assume that individual stocks have a starting value S0i = 1 for all

stocks.

If at time t = 0 we pick a stock S0i at random, then our time T value follows

1

STi ∼ eµˆT − 2 σ

√

2T +

σ 2 T +ˆ

σ2 T 2 Z

,

**where Z ∼ N (0, 1), provided we assume µi and WT are independent.
**

We define

ItN

N

1 X i

=

S,

N i=1 t

**which corresponds to a capital weighted index of N stocks. By the Central Limit Theorem,
**

1 2 2

ITN ≈ E STi = eµˆT + 2 σˆ T

(1)

for large N .

Two observations are apparent. First, the cumulative return of a stock picked randomly

ˆ 2 T 2 ) distribution. The variance component

at time t = 0 follows a log-N (ˆ

µT − 12 σ 2 T, σ 2 T + σ

2 2

σ

ˆ T , which indicates the over-proportional profit a continuously compounded winner will

bring relative to the loss incurred by a loser. That is, the distribution is heavily positively

1 2 2

skewed with a mean of eµˆT + 2 σˆ T . Second, the median of the stock distribution is given by

1 2

eµˆT − 2 σ T , so that over time T more than half of all stocks in the index will underperform

1 2

1 2 2

the index return ITN by a factor of e 2 σ T + 2 σˆ T .

3

Simulation Results

**We assume a median index return of 10% and an expected index return of 50% over the
**

considered period T . We take σ = 20% as a generic annual

√ stock volatility. We choose T = 5

1

2

ˆ = 2 log 1.5 − 0.04 · 5 · 2/5 ≈ 13%. We

(five years), µ

ˆ = (log 1.1 + 2 0.2 · 5)/5 ≈ 4%, and σ

1

In one study of stock market fluctuations, Barsky and DeLong (1993) discuss the problem of estimating a

particular parameter for an assumed dividend process, noting that a Bayesian updater might not be shifted

significantly from his prior after 120 years of data and that “[e]ven if we were lucky and could precisely

estimate [the parameter], no investor in 1870 or 1929-lacking the data that we possess-had any chance of

doing so.”

2

**Figure 1: On the left, overlapping frequencies of over- and underperformance relative to index average
**

return of 50%. On the right, overlapping frequencies of 20% over- and underperformance relative to index

average return 50%. While random selection of small sub-portfolios has the greatest probability of getting

overperformance, it also risks a relatively high probability of underperformance. The risk of substantial index

underperformance always dominates the chance of substantial index outperformance and is greatest for small

portfolios.

**show the frequency of exceeding or falling short of the expected five year, 500-stock index
**

=500

− 1 ≈ 50% when creating sub-portfolios of different sizes (each computed

return EITN=5

based on a Monte Carlo simulation with 10,000 samples). Figure 1 left shows the frequency

with which randomly selected portfolios of a given size overperform (5 year return greater

than 50%) and underperform (5 year return less than 50%) the expected return for all 500

stocks. Figure 1 right shows the frequency with which randomly selected portfolios of a given

size overperform (5 year return greater than 70%) and underperform (5 year return less than

30%) using more extreme thresholds for over- and underperformance.

The risk of substantial index underperformance always dominates the chance of substantial index outperformance, with the difference being greater the smaller the size of the

selected sub-portfolios. It is far more likely that a randomly selected subset of the 500 stocks

will underperform than overperform, because average index performance depends on the

inclusion of the extreme winners that often are missed in sub-portfolios.

3

4

Conclusion

**Researchers have focused on the costs of active management as being primarily the fees paid
**

for active management (e.g., French 2008). Our results suggest that the much higher cost

of active management may be the inherently high chance of underperformance that comes

with attempts to select stocks, since stock selection disproportionately increases the chance

of underperformance relative to the chance of overperformance. To the extent that those

allocating assets have assumed that the only cost of active investing above indexing is the

cost of the active manager in fees, it may be time to revisit that assumption. The stakes for

identifying the best active managers may be higher than previously thought.

References

Barsky, R. B. and J. B. DeLong. (1993). Why does the stock market fluctuate? The Quarterly Journal of

Economics, 108, 291-311.

French, K.R. (2008). Presidential Address: The Cost of Active Investing. Journal of Finance, 63(4), 1537-73.

Gruber, M.J. (2008). Another Puzzle: The Growth in Actively Managed Mutual Funds. Journal of Finance,

51(3), 783-810.

J.P. Morgan. (2014). Eye on the Market, Special Edition: The Agony & the Ecstasy: The Risks and

Rewards of a Concentrated Stock Position.

Jobert, A., A. Platania, and L. C. G. Rogers. (2006). A Bayesian solution to the equity premium puzzle.

Unpublished paper, Statistical Laboratory, University of Cambridge.

Lakonishok, J., A. Shleifer and R. Vishny. (1992). The Structure and Performance of the Money Management

Industry. Brookings Papers on Economic Activity: Microeconomics, 339-391.

Merton, R. C. (1980). On Estimating the Expected Return on the Market. Journal of Financial Economics,

8, 323-361.

Sharpe, W.F.(1991). The Arithmetic of Active Management. Financial Analysts Journal, 47(1), 7-9.

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